Wednesday, August 31, 2011

Does an incentive to stay create an environment for top executive performance?

In uncertain times for a corporation, can an executive incentive package create stability and an environment for the executive team to perform at a high level?

Over the past two decades, executive severance agreements (ESAs) and change in control agreements have become standard ex ante tools for key executives and teams. Their intent is to prevent key executive turnover with large incentives offered to executives who remain in their positions except for "Good Reason" or in a change in control situation.

Severance agreements have received substantial attention from the business press, attorneys, business schools, executives, and investors. Termination of high profile executives from large public companies resulting in substantial severance payments has driven much of this attention. Some institutional investors have proposed that no severance package should exceed 3X
pay, especially in the case of poor performance. While severance agreements with executives can be negotiated post-termination, our focus will on ESAs for currently employed executives or ex-ante employment agreements, change-incontrol
agreements and severance agreements. Some studies by prominent business schools have shown that in excess of fifty
percent of executives have some form of severance agreement and over eighty percent have some form of change-in-control agreement. These studies have also suggested that executives with higher pay are more likely to have a severance
agreement in place, based upon the executive’s bargaining power or strength of firm governance.

Driven by high profile industry examples, leading educational institutions like Harvard Business School have taken up the study of severance agreements. Most studies evaluate the ethics or effectiveness of these agreements on executive and management team performance. But interestingly, the themes of some graduate business school courses and seminars encourage executives to distrust the corporate environment. The recent poor economic environment has led business educational institutions to even promote the view that “businesses don’t really care about you” (HBS, R Gulati, 2011).

Educational institution publications like the Harvard Business Review have developed an executive leadership series, Managing Your Career In Tough Times (2010), with one section titled “The Right Way to be Fired” which promotes ex ante employment and severance agreements. Legal publications, Harvard Law and the New York Law Journal, and their seminars instruct executives on the “negotiating options” for executives in employment, change-of-control, and severance agreements.

While the growth of severance agreements began with large corporations and is taught through leading business schools like Harvard, interest in these agreements has spread to smaller companies and even local graduate business schools where the topic of severance agreements can be found at Purdue’s Krannert and at Indiana University’s Kelley School. Advice and tutorials on how to negotiate an executive employment contract are readily available on the Internet.

In evaluating information on executive employment agreements, change in control agreements and clauses, and executive severance agreements, there is consistent and common language for triggering events and benefits.

Agreements written over a decade ago will go into much greater detail in defining the triggering events for executive employment agreements and executive severance agreements. But as these agreements have evolved the triggering event language is more simplified and focused on three types of executive termination – ‘for cause’, as a result of ‘change-in-control’, and by the executive ‘for good reason’. Rather than detailing many possible termination scenarios, agreements written recently define these three types of terminations as triggering events.

‘For cause’ terminations result in no continuing benefits paid usually past the date of termination. ‘Change-in-control’ and ‘for good reason’ usually trigger a severance benefit agreement or clause. Severance agreements and benefits can be part of the individual executive employment agreement or part of a stand-alone executive severance agreement.

The benefits triggered by these agreements are lump sum payments or continuation of several years of payroll, bonus, and benefits. Some agreements gross up payments to cover excise taxes. Studies at a number of leading business schools suggest that these agreements and their benefits do not provide their intended purpose and in some instances may have created an environment that fostered executive turnover. Current study of severance agreements suggests the possibility that more equity incentive versus cash compensation may better enhance executive performance and corporate stability.


  1. Subject: NYTimes: Outsize Severance Continues for Executives, Even After Failed Tenures

    Eye-popping severance packages thrive in spite of the measures put in place in the wake of the financial crisis to crack down on excessive pay.


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